Short or inverse exchange-traded funds (ETFs) allow investors to take bearish positions on various indexes and ETFs in order to profit if the underlying index goes down. For example, the value of the Short S&P 500 ETF is designed to increase if the S&P 500 index falls.
In addition to regular short ETFs, there are some that are designed to magnify their returns by a factor of two or three. For example, a short 2X ETF fund would increase by 20% if the underlying index fell by 10%, while a short 3X ETF would rise by 30%. These ETFs are often called "ultra" or "leveraged" ETFs.
Investing in inverse ETFs can be quite risky and is therefore not recommended for casual or amateur investors. It is also not recommended as a long-term investment or trading strategy.
By its very nature, shorting stocks, either directly or by buying inverse ETFs, goes against the long-term trend in stock prices, which is overwhelmingly upward. Over the long-term, therefore, inverse ETFs are unlikely to provide positive returns. The very design of most inverse ETFs also reduces their effectiveness as a long-term investment or trading strategy.
This is not to say that inverse ETFs don't have a role to play in investing or trading. Let's look at some of the advantages of inverse or short ETFs.
Inverse ETFs can provide investors with a relatively easy and inexpensive way to profit if they believe stock or bond prices are due to correct or to hedge a long position. Inverse ETFs can be purchased online from a brokerage firm just as easily as every other ETF on the market.
In addition, inverse ETFs enable investors to take a bearish position on an index even through a brokerage account in which shorting stocks or using options is not permitted or restricted, such as in an individual retirement account (IRA).
Buying an inverse or short ETF is also generally cheaper than shorting an asset directly and doesn't require the investor to open a margin account.
Finally, buying a short ETF has limited downside potential, unlike having a short position in an asset, which has unlimited loss potential if the underlying asset continues to increase in value, until the short position is closed. The loss potential in a short ETF is limited to the amount invested in the fund.
However, there are many disadvantages—if not outright dangers—to investing in inverse ETFs, which is why they are not suitable for all investors.
As mentioned, shorting a stock—if not the entire market—goes against the long-term trend in stock prices, which is decidedly and historically upward. Certainly, investors can profit from stocks or the market going down, but bear markets and price corrections are decidedly far less common and short-lived than prices moving higher. As a result, investing in short ETFs should be used as a very short-term strategy only, rarely or if ever long-term.
The way most short ETFs are constructed also militates against using them as a long-term strategy. Most short ETFs don't actually hold a short position in the stocks or bonds in the underlying index but rather they more often use swaps, options and derivatives that are designed to move in the opposite direction of the underlying index.
As a result, they often may not precisely correlate to the underlying long index. For example, if the S&P 500 were to fall 10%, the short S&P ETF may not rise by that same percentage.
Likewise, many short ETFs are designed to move inversely to a specific index on a daily basis only, and not over the long-term. As a result, the returns on a short ETF will not correlate to changes in the underlying index over a longer period.
Indeed, in times of extreme volatility with markets moving up and down, the performance of a short ETF can diverge sharply from its underlying index. This is particularly the case with a 2X or 3X inverse ETF.
Short ETFs also suffer from a relative lack of variety compared to "long" ETFs, which come in many varieties such as stocks, bonds, industry sectors, currencies and individual countries.
The number of available short ETFs is far more limited, but there are several popular ones, such as those that short the S&P 500, the Dow Jones Industrial Average or the FTSE 100. There are also short ETFs that track fixed-income ETFs, such as the ProShares Short 20+ Year Treasury ETF, which is designed to move higher when prices on long-term U.S. Treasury bonds fall, meaning yields rise.
Short or inverse ETFs provide investors with a fairly easy and cheap way to place bearish bets on certain indexes or market sectors. Some short ETFs also come in leveraged varieties that offer double or triple bearish exposure to an underlying index. As a result, short ETFs are usually not suitable for those who aren't professional investors and those with a very short investment horizon or trading strategy.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…